Backgrounder
Foreign Direct Investment
and Recovery in Indonesia:
Recent Events and Their Impact
by Malcolm Gray
Introduction and Summary
Some recent events in Indonesia have raised questions about the future
role of foreign direct investment (FDI) in the Indonesian economy. This
Backgrounder looks at those events and their implications.
FDI is important in the process of economic development, both as a
desirable source of long-term finance and for the skill and technology
transfer often associated with it. In the half century since independence,
the Indonesian economy has had a range of drivers of economic
development.
In the decade-or-so preceding the Asian crisis, FDI had assumed an
important role and Indonesia had been reasonably successful in attracting
it. The Asian crisis and subsequent events did more damage to the
Indonesian economy than to any of the other crisis-affected economies
(usually identified, for example, by the IMF, as Malaysia, the Republic of
Korea, the Philippines and Thailand).
The impact on FDI in Indonesia was particularly marked. As a
consequence of this and related developments, there are particular
vulnerabilities in the economic situation in Indonesia that make the sharp
fall-off in FDI especially damaging. Recent developments may significantly
reduce the prospect of achieving an early turnaround in Indonesia’s recent
poor performance in attracting FDI and reduce the return to the Indonesian
community from major elements of the previously accumulated stock of
foreign investments. This Backgrounder looks at each of these topics in
turn.
August 2002, Vol. 14/2, rrp $13.20
Foreign Direct Investment and Recovery in Indonesia: Recent Events and Their Impact
THE VALUE OF FOREIGN DIRECT
INVESTMENT (FDI)
Value of foreign investment in the
early stages economic development
In the early stages of economic development, a given
increase in capital per worker can have a much more
dramatic impact on output per worker than at later
stages of development when the capital-per-worker
ratio is higher. The restraint in consumption that is
required to provide the funding for such investment
from domestic sources, however, is typically more
difficult because it implies sacrifices in current living
standards that are already low. In these circumstances,
foreign investment provides a way of securing the
gains in output per worker, which are then shared
with the foreign capital provider, without a
corresponding sacrifice in current living standards.
FDI is generally less volatile
can deliver a range of benefits to the host country.
The physical facilities established by a foreign direct
investor often embody technology new to the host
country. Both during the construction and operation
phases of such a plant, management skills may be
channelled through the foreign investor of a kind
either not available or in limited supply in the host
country. The presence of a foreign direct investor
can often facilitate obtaining loan capital for a project
on terms that would not otherwise be available. In
addition, a foreign direct investor may have access
to product markets that would be difficult or
expensive to access otherwise.
DRIVERS OF ECONOMIC GROWTH
IN INDONESIA
In looking at the principal drivers of economic
development, the economic history of Indonesia
since independence can be usefully divided into four
phases: the period up until 1965, from 1965 to
1986, from 1986 to 1997 and the period since 1997.
From the perspective of a developing country, FDI
offers several advantages over alternative ways of
providing such investment, such as foreign portfolio
investment or foreign (typically bank) lending. FDI
typically involves greater assumption of the risks of
From independence to 1965: the
Sukarno presidency
operating in the local environment by the foreign
Through
the period of the Sukarno presidency,
investor, through a longer-term commitment and
increasing reliance was placed on fiscal stimulus
because it is less easy to withdraw FDI than portfolio
financed by money creation. This policy mix gave
investment or a loan. It was noticeable during the
rise to accelerating inflation, a collapse in confidence
Asian crisis that the typical pattern was that bank
and economic stagnation. Inflation peaked at 1,500
loans, many of which were short-term, were
withdrawn very quickly,
followed by portfolio
Chart 1 - Indonesia: Foreign Direct Investment Inflow
and Growth in Real Gross Domestic Product
investment, with FDI
($US millions and per cent per annum- Sources: UNCTAD and IMF)
15.0%
7000
generally responding much
FDI inflow
less and more slowly. The lower
Real GDP growth
RHS
LHS
5000
volatility of FDI is reflected in 10.0%
a lower contribution to
3000
fluctuations in the external
5.0%
accounts of the host country
1000
and, consequently, fewer prob0.0%
lems of economic management
1971
1976
1981
1986
1991
1996
2001
-1000
for the host government.
-5.0%
FDI often provides
additional benefits
Direct investment links the
project to the other operations
of the direct investor, which
2
-3000
-10.0%
-15.0%
-5000
-7000
IPA Backgrounder, Vol. 14/2, 2002
Foreign Direct Investment and Recovery in Indonesia: Recent Events and Their Impact
per cent in 1965, accompanied by food shortages
and high unemployment.
From 1965 to 1986: reform through
planning
The coming to power of President Soeharto in 1965
saw a sharp change in economic policy settings, with
the introduction of multi-year economic plans to
guide development. Oil revenues permitted
government to play a major role in driving economic
development while maintaining relatively
conservative fiscal and monetary policies. The oil price
rises of 1973 were important here. Initially this policy
was very successful with economic growth averaging
8 per cent through the 1970s. As Chart 1 shows,
however, the reliance on government as the principal
driver of growth through increasingly bureaucratic
processes saw growth falter in the early 1980s. The
collapse of the oil market in 1986 made the growing
pressure for a change in economic policy irresistible.
INDONESIA HARD HIT BY
THE ASIAN CRISIS
Indonesia was hard hit by the Asian crisis of 1997–
98 and, after a slow and limited recovery, is again
experiencing slowing growth.
GDP contracted sharply
Although the Asian crisis affected a wide range of
countries, its strongest effects were felt in Indonesia,
Malaysia, the Republic of Korea, the Philippines
and Thailand. The impact on Indonesia was
markedly more severe and long-lasting than the
impacts on the other crisis-affected economies. Real
GDP declined by 13 per cent in Indonesia in 1998,
more than any other crisis-affected economy, and
was slower to recover, remaining below 1 per cent
in 1999.
Particularly reflected in FDI inflows
From 1986 to 1997: freeing markets
All the affected countries suffered massive short-term
capital outflows during the crisis. As depicted in
Chart 2, Indonesia was unique among the crisisaffected economies in suffering substantial and
sustained negative FDI inflow in the wake of the
crisis. (FDI inflow is net direct investment by
foreigners in Indonesia, with FDI outflow being net
direct investment by Indonesians in the rest of the
world.) According to the most recent figures available
from UNCTAD, Indonesia has suffered net negative
FDI inflow in every quarter since the third quarter
of 1998. In Thailand, the crisisaffected economy most similar
Chart 2 - Foreign Direct Investment Inflow
($US millions - Source: UNCTAD)
to Indonesia, FDI inflow
Republic of Korea
actually increased in 1998
before falling back, but
remained above pre-crisisMalaysia
levels. In Malaysia, FDI inflow
fell sharply during the crisis,
Thailand
but has subsequently recovered
to a level close to the pre-crisis
peak. The Republic of Korea
seems to have become more
attractive to foreign investors
1985
1990
1995
2000
in the wake of the crisis, with
Philippines
FDI inflows climbing to more
than four times their pre-crisis
Indonesia
levels. FDI inflow to the
Philippines, another country
In response to the pressures of the early 1980s,
economic policy became more market-oriented,
with private sector investment assuming the role
of the principal driver of economic growth. As Chart
1 shows, these policy changes stimulated FDI and
saw it make a major contribution to restoring
economic growth. In the late 1980s and early 1990s,
economic growth returned to the levels of the 1970s.
This period of strong growth ended in 1997 with
the onset of the Asian crisis.
11000
9000
7000
5000
3000
1000
1980
-1000
-3000
-5000
IPA Backgrounder, Vol. 14/2, 2002
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Foreign Direct Investment and Recovery in Indonesia: Recent Events and Their Impact
often compared to Indonesia, was not much affected
by the crisis and has been broadly maintained at precrisis levels.
Growth slowing
The Indonesian economy finally began to recover in
2000, posting growth of 4.8 per cent, and it seemed
to weather the global slowdown evident in 2001
better than its neighbours. Even so, growth slowed
in 2001 to 3.3 per cent. With the fourth quarter
showing an even bleaker picture, with GDP only
1.6 per cent above its level of the fourth quarter of
2000, growth is generally forecast to be a little over
3 per cent in 2002. Of particular concern in these
figures are the recent poor performance and outlook
for business investment and exports. Recent analysis
has shown that, with growth at these levels, it will
be six more years before per-capita GDP in Indonesia
regains its level of 1997.
THE CURRENT ECONOMIC
SITUATION
Against this background of restricted growth
opportunities and the delay in restoring 1997 living
standards, certain features of the current economic
situation are of particular concern.
Financial restructuring proving
difficult
The Indonesian financial system is struggling to
overcome the legacy of the Asian crisis. The
Government still controls more than three-quarters
of the total assets of the commercial banks and much
corporate debt remains unrestructured. Bank assets
are dominated by government and central bank debt,
with loans at only around one-third of deposits.
About a quarter of distressed corporate debt is
known to have been subject to restructuring
arrangements. Even for that debt, recent World Bank
analysis has raised doubts about whether most of
these arrangements have succeeded in reducing debt
to sustainable levels. Public sector debt is also
substantial, with public debt interest payments
budgeted to consume over 5 per cent of GDP in
2002, making it the largest single line item. Some
progress is, however, being made. The Indonesian
Bank Restructuring Agency (IBRA) disposed of 51
4
per cent of Bank Central Asia, Indonesia’s largest
retail bank, in March. The process for the sale of 51
per cent of Bank Niaga was, however, suspended in
early June. IBRA is now making limited volumes
of shares available on the Jakarta Stock Exchange
with the avowed aim of testing the market price.
The price of Bank Niaga shares has fallen by about
36 per cent in the six weeks to I July 2002.
Legal System Increasingly
Unpredictable
A number of very high-profile cases have emerged
where the Indonesian legal system has provided
directions in the way commercial rules are applied
that appear to undermine the confidence of
international investors. The cases have all been very
high profile, and have involved bankruptcy
proceedings initiated against viable businesses, the
attachment of assets to actors in closely contested
commercial cases, and the abrupt seizure of assets
on the basis of questionable outlines of events.
Privatisation programme behind
schedule
The privatisation programme failed to meet its
targets in each of the last three years. There were
essentially no sales of state-owned enterprises in
1999 or 2000, and only a minority stake in PT
Telcom was sold in 2001. Of particular concern is
the role of regional government in preventing the
sale of a controlling stake in PT Semen Gresik to
Cemex, a Mexican company, discussed in more detail
below. In both the privatisation programme and the
IBRA’s programmes, doubt has arisen about the
preparedness of the Indonesian authorities to dispose
of assets to foreign companies.
Problems emerging from
decentralisation
In 1999, the Indonesian parliament passed laws 22
and 25 that mandated the introduction of a
substantial programme of decentralisation
beginning on 1 January 2001. Thus far, the
programme has involved increasing the share of subnational governments in total government
expenditure from 13 per cent to 35 per cent and
transferring more than two million people from
national to sub-national government employment.
Although the transition was, in many respects,
remarkably successful, with minimal disruptions to
IPA Backgrounder, Vol. 14/2, 2002
Foreign Direct Investment and Recovery in Indonesia: Recent Events and Their Impact
service delivery or local government operations, some
problems have begun to emerge. Mention has already
been made of the role of sub-national governments
in the attempted privatisation of Semen Gresik. In
addition to increased grants from the national
government, local governments were given broader
taxation powers. Although new taxes and charges
were to be subject to review by the national
government, the principles established have proved
vague and hard to administer. In spite of many
reports of excessive charges and of disruptions to
business from the new restrictions imposed, the
national review body has not rescinded any of the
new measures. Decentralisation has also seen the
power to set minimum wages passed to the
provincial governments. In a number of cases, most
notably in Jakarta, excessive increases have been
granted which have dissipated much of the
competitiveness gained from the 40 per cent real
depreciation of the rupiah.
A critical role for FDI
Growth in investment fell sharply in 2001 and is
widely predicted to fall further in 2002. Reestablishing strong growth in investment is vital to
increasing efficiency and securing a sustainable
recovery. As discussed earlier, domestic private
capital markets are currently in no condition to
provide the level of funding required. The
government is already under pressure from the IMF
to reduce the budget deficit and is therefore poorly
placed to provide further economic stimulus. Indeed,
the task of bringing the burden of public debt
interest under control is already substantial.
Resistance to the sale of state-owned assets to
interests likely to operate them more efficiently is
doubly unhelpful. In these circumstances, foreign
investment, and particularly FDI, is more valuable
than ever.
RECENT DEVELOPMENTS AND
THEIR IMPACT
A number of recent developments have increased
the level of uncertainty for investors in Indonesia.
Although some of these—such as the increase in
taxes, charges and restrictions on business, and the
hikes in minimum wages—impact generally, others
have raised particular questions about the future
IPA Backgrounder, Vol. 14/2, 2002
environment for FDI in Indonesia. Three cases arise
from problems in relations between local and
national governments: Semen Gresik, mentioned
earlier, Kaltim Prima Coal (KPC) and the Caltex
operation in Riau province. A fourth, Manulife
Indonesia, raises fundamental questions about the
administration of justice in Indonesia.
Caltex
In October 2001, the Indonesian parliament passed
a new oil and gas law. This removed the monopoly
over Indonesian oil and gas resources previously
enjoyed by Pertamina, the state-owned oil company.
Subsequently, the government of Riau province in
north-east Sumatra secured a 50 per cent interest,
effective from August 2002, in the large oil fields
known as Coastal Plains Pekanbaru (CPP) in the
province. The field is currently operated by US
company Caltex Pacific Indonesia under an extension
to its production-sharing contract which is due to
expire in August 2002. This contract divides
production from the field between Caltex, 15 per
cent, and Pertamina, 85 per cent. The lack of an
adequate return to the province in these
arrangements has been a source of friction between
the national and provincial governments. It has been
reported that the provincial government and
Pertamina propose to form a joint venture to take
over operation of the oil field from Caltex. Other
reports have identified interest in participating in
the management of the oil field from a consortium
of interests from South Africa, Great Britain, Saudi
Arabia and Malaysia. In any event, this would seem
to be the first time that a foreign operator has been
replaced under a production-sharing contract, rather
than an extension or renewal being worked out.
Some fears have been expressed about whether the
new operator will be able to manage the
sophisticated recovery techniques that the field now
requires or provide the additional investment
needed. Caltex is Indonesia’s largest foreign investor,
employs 6,000 people and produces about half of
Indonesia’s oil output.
PT Semen Gresik
Cemex is a Mexico-based company with a 25.5 per
cent interest in PT Semen Gresik, Indonesia’s
largest cement maker. The Indonesian Government
owns the balance of the equity, but has a
longstanding agreement with Cemex that would
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Foreign Direct Investment and Recovery in Indonesia: Recent Events and Their Impact
allow Cemex to buy it out. The provincial
governments of West Sumatra and South Sulawesi
recently combined to block the sale of further shares
in Semen Gresik to Cemex by demanding that the
operating units in their jurisdictions not be
included in the sale.
KPC
KPC is a 50–50 joint venture between Rio Tinto
and BP. It operates a large coalmine, widely
regarded as the highest quality in Indonesia, in
Kalimantan. Under its contract of work with the
Indonesian Government, the joint venture was
required to offer up 51 per cent of its interest in
KPC to Indonesian parties by 2001. The joint
venture had made various unsuccessful attempts to
do this. On 18 March 2002, KPC reached an
agreement with the Indonesian Government on the
price of $US419m for offering 51 per cent of the
company to Indonesian parties by 31 March. Before
this offer could occur, the provincial government
of East Kalimantan obtained an order in the South
Jakarta District Court preventing any transfer of
shares and freezing most other holdings of Rio Tinto
and BP in Indonesia. The provincial government
sued KPC for $US776 million in lost dividends
(past and future), due to delays in the divestment
and demanded that the shares be offered exclusively
to it. This demand of exclusivity was inconsistent
with KPC’s contract of work with the Indonesian
Government.
KPC subsequently reached agreement with the
Indonesian Government to offer 51 per cent of its
shares to the Indonesian Government for assignment
to other Indonesian parties, including the provincial
government, on 31 July 2002. The provincial
government withdrew the legal action, but it
continues to seek entitlement to the whole 51 per
cent of shares on offer.
Manulife Indonesia
In 1999, the Canadian insurer Manulife, parent of
one of Indonesia’s largest life insurers, Manulife
Indonesia, attempted to buy out its bankrupt local
partner. In response, a series of bankruptcy claims
were filed against Manulife Indonesia in the South
Jakarta District Court culminating in a courtappointed administrator seizing the company. The
move prompted the intervention of the Canadian
Government, and led to IMF calls for the reform of
6
Indonesia’s commercial court, the revision of its
bankruptcy law and the establishment of an anticorruption commission. The Indonesian Supreme
Court recently rejected the bankruptcy ruling of
the lower court, but the strength of that rejection
has been questioned by leading Indonesian lawyers
and the plaintiff is reported to be considering the
possibility of further legal action.
IMPACTS
A common element
The first three cases each involve a provincial
government asserting new rights of ownership or
control over enterprises located within its borders.
Although friction between the national and
provincial governments (for example, over the
distribution of revenues form resource projects), is
longstanding, these recent events seem to have been
triggered by the decentralisation reforms put in
place last year. Those reforms did not, however,
grant the rights that are now being claimed.
Rather, these claims are based on the political
power of the provinces relative to the national
government.
Caltex
In the case of Caltex, the national government has
essentially gifted half of the rights over the CPP,
previously held on its behalf by Pertamina, to the
government of Riau. Although precedent suggests
that Caltex could have a reasonable expectation
that its production-sharing contract would be
renewed, it had no formal legal rights.
Nevertheless, the apparent arbitrariness and
unpredictability of the unfolding events increase
uncertainty for investors.
Cemex
In the case of Cemex, action by provincial
governments is effectively preventing the company
from exercising an option, which it obtained through
an agreement with the national government, to
purchase the balance of the equity in Semen Gresik.
Cemex is losing the value of the option and the
national government is losing the immediate
revenue from disposal of the equity and casting
doubt over its broader programme of privatisation.
The avowed concerns of the provincial governments
are the possibility that Cemex will lay off workers
IPA Backgrounder, Vol. 14/2, 2002
Foreign Direct Investment and Recovery in Indonesia: Recent Events and Their Impact
at plants located in their jurisdictions, but there is
also a strong undercurrent of political dispute about
the national government’s right to exercise control
over these plants. Cemex maintains that Semen
Gresik needs US$100 million in fresh investment
in the next five years to remain competitive in this
region and reports suggest that there is significant
scope for improving the efficiency of the overall
operations. Neither the national nor the provincial
government are well placed to meet these needs.
KPC
In the case of KPC, the provincial government has
intervened and blocked an agreement between the
national government and KPC that would have
enabled KPC to discharge its obligation to offer
shares. On the face of it, the demands of the
provincial government seem ridiculous: exclusive
rights to purchase the interest in KPC on behalf of
a group of private investors and a claim for damages
that seems to include future possible earnings but
excludes the cost of buying the shares. Various
reports have identified a range of private business
interests alleged to be backing the provincial
government, but the precise benefits to that
government of achieving this outcome remain
unclear. Perhaps of more concern is the longer-term
management of KPC after divestment. The
operation is large and has demanded substantial
capital to establish and maintain it. In addition,
getting the best returns from selling thermal coal
in the volumes produced by the mine into relatively
depressed global markets requires a high degree of
marketing skill. Failure to continue adequately to
meet these demands of the operation would clearly
damage both the provincial and national economies.
Manulife Indonesia
The threatened bankruptcy of Manulife Indonesia
would immediately deprive many Indonesians of the
insurance cover for which they have paid, in spite of
the fact that the company has a demonstrated
capacity to continue to provide that cover. Although
it has not provided a specific figure, Manulife has
acknowledged that legal action to date has cost it
‘millions of dollars’. Significantly, Manulife is one
of the few large international companies to have
made a substantial investment in Indonesia since
the 1997 crisis. Its experiences are hardly likely to
induce other companies to follow its lead.
IPA Backgrounder, Vol. 14/2, 2002
IMPLICATIONS
These cases have clearly created considerable
confusion about private property rights and about
the rights and responsibilities of the different levels
of government in Indonesia. Consequently, the
uncertainty confronting investors, particularly
foreign investors, has substantially increased,
creating a significant deterrent to further
investment. The potential loss of capital and
managerial expertise in these four cases alone would
impose significant costs on the national economy.
The Cemex case has had an immediate and direct
effect on the revenues of a government facing very
significant fiscal challenges. The Manulife case has
placed the operations of the Indonesian legal system
under close international scrutiny. Overall, these
events have called into serious question Indonesia’s
capacity to pursue urgently needed reform.
CONCLUSIONS
ADB’s views clear
In its recent Asian Development Outlook 2002, the
Asian Development Bank (ADB) had these things
to say about Indonesia:
Spurred by rising exports, increased investment
was one of the factors that helped pull the
economy out of recession in 2000 and early
2001. However, FDI inflows faded as global
markets weakened in 2001. More important
to longer-term prospects, there has been a
widespread perception that the policy
environment for investment in Indonesia has
turned harsh and unsupportive. In the first 10
months of 2001, only $6 billion of FDI projects
were approved, roughly equal to one third of
the total approved during the comparable
period in 2000. Because the fall in investment
predates the September attacks on the US, it
would seem to be part of the broader, longerterm problem of capital flight seen in Indonesia
since the financial crisis. Continuing problems
of financial governance, lack of credibility of
the legal and judicial system, and political
uncertainty have all discouraged investors from
making longer-term commitments. The
Capital Investment Board noted that only
about 10 per cent of previously approved
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Foreign Direct Investment and Recovery in Indonesia: Recent Events and Their Impact
projects—both domestic- and foreignsponsored—were likely to be realized this year.
The political problems hindering attempts to
sell state-controlled assets are one of the
symptoms of the broad negative investment
sentiment.
All this is occurring precisely at a time when
Indonesia desperately needs to encourage private
capital inflow. Inflows of official assistance fell in
2001 and will fall further as policy adjustment loans
tail off. The current account surplus is shrinking
and the net foreign exchange reserve position
deteriorated by over 6 per cent in 2001
Damage threatened as vulnerability
is greatest
Uncertainty must be resolved
Indonesia is clearly wrestling with a number of
economic and political problems. The relationship
between the various levels of government is closely
entwined in many of them. Decentralisation has long
been called for, and many aspects of the reforms have
been carried through successfully. It has become
clear, however, that there are areas in which lack of
clarity about rights and responsibilities or, perhaps,
lack of appreciation of the consequences of certain
policy actions is beginning to threaten serious
damage to the national economy. The climate for
investment in Indonesia was severely damaged by
the Asian crisis and has suffered further from the
continuing uncertainty about the policy
environment. These latest events threaten to make
an already difficult environment even less attractive.
According to the ADB, ‘growth in the 7–10 per
cent range is necessary to reduce poverty in a
sustainable fashion and to meet the Government’s
long-term development goals’. Growth looks set to
weaken in 2002 and, even factoring in some
improvement in external markets in 2003, will still
fall far short of this target range. The current state
of Indonesian public finances means that economic
growth cannot be driven from the public sector as
it has been in the past. The private sector must play
the dominant role. Given the parlous state of
domestic financial markets, improving the
environment for foreign investment is clearly a high
policy priority. But that will not be achieved while
the uncertainty engendered by recent events is
allowed to remain.
ABOUT THE AUTHOR
Malcolm Gray has worked in academia in the UK, US and Australia, occupied senior positions in
the Commonwealth Public Service, including a period in the Prime Minister’s Office, and was
Group Economist at CRA Ltd, now Rio Tinto Ltd, for two years. He has been involved in
teaching and research in economics, the development of a wide range of public policies, and the
strategic management of a large, transnational public company.
Malcolm’s teaching and research concentrated particularly on macroeconomic policy in an open
economy with a particular emphasis on the role of financial markets. He has been closely involved
in a range of important public policy initiatives, including in industry policy, science and
technology, telecommunications, the Special Premiers Conferences and the reform of industrial
relations. As Group Economist at CRA Ltd, he headed a small unit that provided analysis of broad
developments in the world economy and conditions and outlook in the markets for specific mineral
commodities, providing briefings that contributed to the company’s strategic decision making.
This Backgrounder published by the Institute of Public Affairs Ltd (A.C.N. 008 627 727)
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IPA Backgrounder, Vol. 14/2, 2002